The net profit (also known as profit before tax) is shown in your financial statements on the profit and loss account, after sales, cost of sales (also known as direct costs), overheads, interest and depreciation. It tells you what the business made for the period being reported on.
It may look something like this
Cost of sales £(70,000)
Gross Profit £30,000
Net profit £15,500
Net profit margin % 15.5%
Most businesses will have similar types of costs in overheads. Overheads are costs that are not directly related to sales. Overheads usually include costs such as rent, telephone, travel, motor expenses, insurance, computer expenses, legal and professional fees etc.
Whereas gross profit is used to look at how the direct trading activity of the company is performing, net profit is used to look at how the business is performing in its entirety.
For example, in a construction company the construction projects may be performing well, however if a significant amount is spent on advertising to bring in clients, or large rent on an under utilised office is being paid, then the company overall may not be performing so well. This would show up in net profit.
By tracking net profit you can see how much your business is making, estimate potential tax liabilities and determine the money available to distribute as dividends or drawings.
Net Profit Margin (%)
Net profit margin is expressed as a percentage. It is the percentage of net profit compared to the sales, the formula being net profit/sales x 100 = Net Profit Margin % (NPM).
It is an important indicator for your business, and can tell you a lot about how the business is performing and how strategies adopted in the business and external factors have influenced the business.
Net profit margin can fluctuate more compared to gross profit margin. Whereas with gross profit margin, if sales doubled we would expect the margin to say the same, as direct costs would most likely double too, with net profit we wouldn’t expect the margin to stay the same.
If sales doubled, that doesn’t necessarily mean overheads would double as there is usually a base cost for overheads, then a variable cost on top. For example, if sales doubled, it doesn’t necessarily mean you need an office twice the size, so rent wouldn’t double.
Advertising may increase, as that could have generated the additional sales, whereas telephone, insurance, professional fees may not increase.
Therefore as sales increase, we may see an increase in net profit margin, however as the business grows at some point we may see it drop. Eventually you may outgrow your office, and the rent will increase and the margin drop.
By reviewing the net profit margin regularly you can see how decisions you are making and external factors are affecting the business. You can also see how investments in overheads are performing.
It is common for an increase in overheads to be seen as negative. However overheads are sometimes an investment into the business. If advertising has increased but sales have increased due to the advertising campaign, then the increase in advertising isn’t negative, it is as expected and a good investment.
If you would like to find out more about how we can help you track the key performance indicators and metrics in your business please contact us here or find out about our virtual finance director service here.